Puerto Rico's broken promise

We do not believe Puerto Rico’s recent default poses broader contagion risk to the municipal bonds market, but it marks the beginning of a long process to repair the country’s economy.

12 July 2016

Philip Villaluz

Head of Municipal Credit Research

Puerto Rico defaulted on roughly $900 million in principal and interest due on 1 July, most of which was general obligation (GO) bonds and Commonwealth-guaranteed debt.

Despite this historic default, which is the first state or US territory to default since the State of Arkansas in 1933, the municipal market has taken it in its stride. In fact, prices of Puerto Rico bonds are generally flat (increasing by 3.4% since introduction of legislation in the US House; declining by 2.8% following the default).

While the default had been expected by the market for quite some time and risk premium priced in, we think this event marks only the beginning of a long process to restructure debt and repair Puerto Rico’s (also known as the Commonwealth) economy and fiscal house.

Debt breakdown

A deteriorating situation has led to a shift in investor base

Puerto Rico has suffered from a recession since 2006; where current unemployment is close to 20%, roughly 50% of the population lives in poverty and hundreds of thousands who have the means have already left the island.

The Commonwealth’s pension fund stands at a less than 1% funded rate, with thousands of retirees who rely on the payments to make ends meet.

Due to a decade of economic and fiscal woes, the Commonwealth amassed $70 billion in debt which was bought by islanders and US municipal bond investors who benefit from triple tax-exemption (income is exempt from federal, state and local taxes).

As Puerto Rico credits drifted into junk bond territory over the past few years, mutual funds sold most of their Puerto Rico bonds; only 125 mutual funds actually hold the bonds, and seven of those funds have more than 50%, according to Morningstar. Opportunistic hedge funds are now the largest holders of Puerto Rico debt.

Decision to break its promise

With liquidity nearly exhausted, Puerto Rico Governor Alejandro Garcia-Padilla announced the Commonwealth’s intention to default on its obligations. He successfully pushed through legislation earlier this year to allow the government to decide whether to make payments on its debt—specifically, its general obligation debt which carries a constitutional guarantee—in order to conserve cash. Puerto Rico itself – like states of the US – does not have the legal authority to declare bankruptcy.

Congress acts

On 30 June, Federal legislation called PROMESA (Spanish for “promise”) was passed, creating an Oversight Board consisting of seven appointed officials, with the “exclusive control” to enact and enforce fiscal plans, so the island attains fiscal solvency and access to the capital markets.

The Board would have ultimate control over all economic and fiscal matters for the government and would have the authority to restructure its debts. It would also have the authority to prevent the execution of legislative acts, executive orders, regulations, rules and contracts that undercut economic growth initiatives or violate the Act, in addition to other powers.

The seven members—appointed by the President with recommendations from leaders in the House and Senate—will likely consist of four Republicans and three Democrats with experience in municipal bond markets, finance, or government operations who cannot be a former or current elected official or candidate for office, among other restrictions.

PROMESA states that any debt restructuring must respect the relative lawful priorities or lawful liens, as may be applicable, in the constitution, other laws, or agreements of a covered territory or covered instrumentality in effect prior to the date of enactment of the Act.

To impose a voluntary restructuring agreement on a specific pool of creditors (i.e., GO bondholders, COFINA bondholders, etc.), a two-thirds vote with at least 50% of the creditor pool voting is needed (based on amount outstanding). This would effectively allow one-third of bondholders to bind the entire group. However, if no agreement is possible, the Oversight Board could then petition a court to force an involuntary restructuring.

It also establishes a firewall between creditors and pensions in the development of fiscal plans.

The Board will be terminated when the Commonwealth government

(i) has adequate access to short- and long-term credit markets at reasonable rates;

(ii) has four consecutive years’ worth of budgets in accordance with modified accrual accounting standards; and

(iii) balances its budget

Helped to default

We think that the passage of PROMESA may have facilitated the GO default, because it initiated a stay of litigation against the Commonwealth through 15 February, 2017. Hence, PROMESA wouldn’t excuse a default, but gives Puerto Rico cover.

Insured bondholders protected

Investors who hold insured Puerto Rico bonds will be paid their amount owed in full, with bond insurance policies making up the shortfall. We also remain confident that the two bond insurers, Assured Guaranty and MBIA (through National Public Finance), with the largest insured exposures to Puerto Rico will continue to pay as expected.

This is not the end

PROMESA is more the start than the conclusion of the process that will determine outcomes for creditors. The restructuring process is contentious and time-consuming. Furthermore, it forces courts to opine over the power of Puerto Rico’s Constitution and the definition of government resources in determining priority of claims between different bondholders (i.e. GO and COFINA) across a very complex debt structure. Creditors may also challenge the constitutionality of PROMESA, which could delay the process even more.

For comparison, the municipal market has recently witnessed other restructurings, albeit on much smaller scales. These include the City of Detroit’s restructuring which took nearly a year and a half; Jefferson County, Alabama took over two years and San Bernardino, California remains ongoing after almost four years.

We think that the situation remains fluid and not enough is known, particularly with regard to private negotiations and formation of the Oversight Board, to make any confident predictions or take a more constructive view on Puerto Rico’s bonds.

However, we emphasise our belief that Puerto Rico’s crisis does not pose a contagion risk to the broader municipal market. We will continue to monitor developments and provide regular updates.

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